A Look At The Value Of Travelers’ Investment Income; $94 Fair Value

The Travelers Companies, Inc. (NYSE:TRV) is the sixth largest property and casualty insurer in the U.S., with a market share of 4.5%, in terms of premiums earned. [1] We have revised our price estimate for Travelers to $94, implying a premium of 10% to the market price. In our valuation model, we have divided the company into three business divisions: Business and financial insurance, personal insurance and investment income.

In this article, we discuss investment income and its importance. One of the key elements that distinguishes Travelers from other P&C insurers is its profitability. While many of its peers, including market leader State Farm, run on underwriting losses, Travelers has managed to maintain underwriting discipline to achieve underwriting profits in four of the last five years.

Insurance companies collect premiums from clients in exchange for coverage, and the income from these premiums is invested, primarily in securities like government and corporate bonds, to generate returns for the company. The insured party is later paid claims if it incurs losses that are covered by the policy.

Insurers are also required to maintain a reserve to pay out claims as and when required. The solvency ratio is used to measure a company’s ability to meet obligations and is calculated by dividing the net written premiums by capital and reserves. Most states in the U.S. have their own regulations and requirements for solvency ratios. Although federal participation in regulation is minimal, the National Association Of Insurance Commissioners (NAIC) ensures coordination among state bodies. The organization is a collaboration between the authorities from each of the states and helps in coordination and establishing standards, including risk-based capital requirements. Following the 2008 financial crisis, President Obama passed the Dodd–Frank Wall Street Reform and Consumer Protection Act in 2010. This established the Federal Insurance Office and the Financial Stability Oversight Council (FSOC) to monitor the insurance market in the U.S.

The policyholder money that insurance companies invest is called “float”. This float is generally shown as a liability on a company’s balance sheet as it needs to be paid back to policyholders, but is actually the most valuable item for an insurer.

Cost Of Float And Underwriting Discipline

The cost of float can be defined as the ratio of underwriting loss to average float. [2] If an insurance company is reporting an underwriting profit then it is essentially being paid to invest a policyholder’s money. This can be achieved with prudent underwriting where the company accepts only the risks that it can properly evaluate. P&C insurers go to great lengths to maintain underwriting discipline.

However, most companies are not able to maintain an underwriting profit and generally have to incur an underwriting loss to generate money for investment. Some companies might also cut rates, thus taking on underwriting losses, to gain market share. This practice can be detrimental in the future as the companies are assuming substantial risk and uncertainty. The P&C industry as a whole has run on underwriting losses for 37 of the last 45 years. [3] However, with near-zero interest rates cutting into investment income, insurance companies might push harder for underwriting profits in order to compensate for the loss of investment income.

It must be noted here that a company’s income statement does not provide the full details of the claims incurred by the company. Instead it includes best estimates or provisions for claims that have been reported but not settled, and for claims that have not yet been reported, often referred to as incurred but not yet reported (“IBNR”) reserves. Company estimates have been proven wrong (in some cases quite drastically) in the past, [4] but the claims and claim adjustment expenses line on the income statement generally provides a good measure of how an insurer is doing on the claims front.

So What About Travelers?

With the exception of 2011, when Hurricane Irene and Tropical Storm Lee led to high catastrophe related losses, Travelers has reported an underwriting profit from its insurance operations. The company even withstood the devastation of Superstorm Sandy in 2012, with an underwriting profit of $226 million for 2012 and a GAAP combined ratio (expenses to premiums) of 97%. In 2010, the company’s combined ratio was 93%, a very healthy figure for a P&C company. In contrast, the combined ratio for Hartford was 109% in 2012 and 110% in 2011. In other words, the company was incurring underwriting losses.

From Travelers’ balance sheet, we can see that the company’s float has been around $48 billion for the last five years. The cost of float – the ratio of underwriting loss to average float – has been around -2.5% excluding 2012 and 2011, which were high catastrophe years. This means that the company is effectively being paid by policyholders to hold and invest money.

Investments made by the company also include a portion of its retained earnings and debt. While Travelers’ float has been more or less constant, its total investments increased from $72.7 billion in 2011 to $72.8 billion in 2012. This growth came primarily from retained earnings, which increased from $19.5 billion in 2011 to $21.3 billion.

Given the low interest rate environment, we expect Travelers to maintain its underwriting discipline, even if it means losing out on market share. As a result, float will remain stable while the net income generated will provide for modest growth in investments.

Where Does Travelers Invest Its Float?

At the end of 2012, Travelers had around $73.8 billion in invested assets. Around 93% of these assets were invested in fixed maturity and short term investments. Equity securities and real estate investments comprised 1% of the investments each.

Of the $65.3 billion invested in fixed maturities, $38.7 billion (59%) was invested in municipal bonds, with $4.2 billion in the state of Texas, followed by $2.3 billion in California. Municipal bonds came primarily from the water and sewer and higher education sectors.

U.S. Treasury securities and debt issued by foreign governments each accounted for 3% of the fixed maturity investments. Travelers has largely steered clear of the European debt crisis, with Canada and the U.K. accounting for most of its foreign debt investments, with smaller contributions from Norway and Germany. Mortgage- backed securities, collateralized mortgage obligations, and pass-through securities accounted for 5% of investments. Corporate bonds and redeemable preferred stock made up the rest of the investments. The highest investment in corporate bonds was in the industrial sector, which accounted for $12 billion (18%) of the fixed maturity investments.

Seeing the investment portfolio, it is no surprise that 85% of the $2.9 billion net investment income comes from fixed maturity securities. The net yield from invested assets has been around 4% over the last few years but we expect a decline in the yield in the coming years, particularly since the returns from investments in bonds are largely dependent on interest rates. The persistent low interest rate environment is expected to last for the foreseeable future. Low interest rates will reduce the returns available on short-term investments and new fixed maturity investments. including those purchased to re-invest maturities. As such we expect a short term reduction in yield with a long term rebound coinciding with a global macroeconomic recovery.

But What Is Travelers Worth?

To arrive at a price estimate for Travelers, we have used a modification of the dividend discount model (DDM). In our model, we are estimating the total income that can be returned to shareholders – through dividends and share repurchases – and discounting this value back to the present.

Travelers usually returns a fair chunk of its earnings to shareholders. In 2012, The adjusted payout ratio, taking into account the common stock dividends and share repurchases, was 85%. However, as discussed earlier, the company will be relying on retained earnings to grow invested assets to support its investment business. As a result, in the longer term it will have less income that can be returned to shareholders. We expect the adjusted payout ratio to drop to 75% by 2015 after which a recovery in the macro-economic environment will allow a higher rate to be returned to shareholders. We expect the payout ratio to reach 77% by the end of our forecast period, implying a terminal return on equity (ROE) of 11%. You can modify the interactive charts in this series of articles to gauge the impact a change in our forecasts will have on our price estimates.

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